Generous parents and grandparents frequently look for the most beneficial ways to give their descendants a head start, often by putting funds aside in an investment for their benefit. This has perhaps become more common during the pandemic, as those who have been fortunate enough to have continued employment, and retirees, have seen their expenses decline with a corresponding rise in their savings. There are a number of different approaches available, each with its own pros and cons, and this article will expand on each.
Formal Trust account
This option requires a Trust Deed to be drafted and tax filings made annually for the Trust. This option is by far the most costly as it requires a lawyer to draft the Trust documentation and an accountant for tax advice and filing. However, it’s also the best from a legal and planning basis as the Trust Deed is legally binding and the purpose of the Trust is explicitly laid out. Typically, formal Trusts are used for larger amounts of money (starting at perhaps $100,000), given the cost and upkeep required.
Pros:
- The Trust documents are legally binding.
- Assets within the Trust are generally protected from creditors, potential divorce claims, and also avoid probate fees.
- Allows for any kind of plan for distributing the assets to the beneficiaries.
- Income is not taxed in the hands of the person who contributed the assets to the Trust (but see below).
- Allows more tax planning than the other options.
Cons:
- Significantly more costly than the other options and requires more ongoing upkeep (both from a “labour” and “money” perspective).
- Though income is generally taxed in the hands of the Trust, Trust income is taxed at the highest marginal tax rate.
- The 21 year rule means any unrealized capital gains are required to be realized every 21 years.
“In-trust-for” (ITF) account, a.k.a. “informal trust”
As long as this is set up properly, this is a legally binding trust. Because the relationship to the child is deemed to be “not arm’s length”, interest and dividend income are taxable in the contributor’s hands but realized capital gains are taxed in the beneficiary’s hands. It has the important benefit of being much cheaper compared to a formal Trust with costs comparable to opening a regular investment account for an adult.
Pros:
- Inexpensive to set up. Costs would be the same as setting up any other taxable account, if any.
- Annual tax filings would be done at the same time as regular personal income tax filings.
- Assets can be easily distinguished based on the objective of the funds since the accounts will have a clear designation. For example, the account’s name could be “Linda Brown In Trust For (ITF) Aidan Brown”.
- If the parent is not in the highest marginal tax bracket, taxation of interest and dividend income within the accounts would be lower than in a formal Trust, and the trustee could be the parent with lower income and thus lower tax rate. Realized capital gains are also taxed in the beneficiary’s hands, who will typically pay no or very little tax as a result.
- When the child reaches age of majority, the accounts are legally the beneficiary’s and all income and capital gains are taxed in the child’s hands.
Cons:
- Interest and dividends are still taxed in the contributor’s hands before the beneficiary turns 18.
- The beneficiary legally takes ownership of account when they turn 18, and they may use the funds for a different purpose than the parents intended.
- The gift to the minor beneficiary is irrevocable. This has been upheld in court. (In Trust Accounts: the Good, the Bad and the Ugly)
“For” account
A “for” account means an individual non-registered account with an internal designation at the financial institution that the funds are intended for another person. Legally, this is not different from a typical non-registered account owned by the parent or grandparent, and taxation is treated the same as such an account. However, the designation can help the contributor keep track of assets more easily.
Pros:
- Inexpensive to set up. Costs would be the same as setting up any other taxable account, if any.
- Since the assets remain legally owned by the contributor, the designation can be revoked.
- Internal designation allows for easily keeping assets segregated from assets intended for personal uses.
Cons:
- There is no flexibility nor benefit with regards to tax planning. All interest, dividends, and capital gains are taxable in the contributor’s hands.
- Does not confer creditor protection.
Tax Free Savings Account (TFSA)
This plan means using a Tax Free Savings Account for the benefit of another person. This requires sufficient and available TFSA contribution room for at least one parent (or contributor). This is essentially the same plan as the “for” account, but allows the benefit of tax sheltering for the assets within. From the perspective of the family’s overall wealth, if the contributors’ TFSAs are already maxed out, this does not really confer a benefit. The parents would be sacrificing their own TFSA room for the benefit of the child. There is more information about TFSAs on our Financial Planning FAQ.
Pros:
- All income (capital gains, dividends, interest) are not taxable, and there are no taxes on withdrawal. All the regular benefits of the TFSA apply.
- Inexpensive to implement.
- TFSAs are flexible. There are no tax consequences for taking money out, withdrawn money can be re-contributed later on, and there are no restrictions on withdrawals or spending, unlike an RESP. If the funds are withdrawn and gifted to the child (say, at age 18) the contributor could make a contribution for their own or someone else’s benefit the following year.
Cons:
- Requires sufficient TFSA contribution room that will be unused if this plan is not adopted. Otherwise, the plan simply substitutes the parent’s TFSA room for the benefit of the children.
- Because a TFSA is intended only to benefit the contributor, it will be more challenging organizationally and to ensure assets are kept segregated.
- There is a maximum amount that can be contributed to the accounts due to the lifetime TFSA contribution limit and annual additional room granted.
- Since TFSA room is only granted to Canadians age 18 and above, if the assets are valued at more than $6,000 (as of 2022) when the child reaches age of majority, there will be tax considerations on some of the assets if gifted to the child directly.
Registered Education Savings Plans (RESPs)
RESPs are tax advantaged accounts that allow enhanced saving for higher education. They can be set up for one or multiple beneficiaries, and through special group RESPs[1]. The contributor and beneficiary(ies) must be Canadian. There is more information on RESPs on our Financial Planning FAQ.
Pros:
- Investments grow tax free within the RESP.
- Canada Education Savings Grants allow for matching contributions up to 20% a $2,500 contribution per year, per beneficiary, up to a lifetime total of $7200. (Larger grants and bonds are available if family income is below certain amounts.)
- If the child doesn’t pursue an approved post-secondary program, contributions and investment growth, but not grants, may be transferred tax free to sibling’s RESP or to a parent’s RRSP (if they have sufficient contribution room).
- When withdrawn to support educational purposes, earnings and grant are taxed in the hands of the student, typically in a lower tax bracket.
Cons:
- RESP earnings will be subject to taxes when withdrawn (though they are taxed in the student’s hands and thus at a low tax rate).
- Less flexibility: tax penalties and grant clawbacks discourage early withdrawal of funds.
- Only the subscriber can withdraw from the account.
- Grant may only be sent to the beneficiary that received it, and not (for example) their siblings.
- If unused, RESP contributions will be transferred to contributor, earnings are taxed plus a penalty, and grants are returned to government.
- A maximum of $5,000 of grant and investment growth (EAP) can be withdrawn in the first 13 weeks of schooling.
In summary, many parents and grandparents find that the best thing they can do with money they do not personally need is to give it to their descendants. As this essay shows, there are a number of options, some of which are very hard (or impossible) to unwind. We are happy to help with your planning.
[1] Group RESPs are typically available through RESP-only institutions and have been criticized for high costs and withdrawal penalties: https://www.cbc.ca/news/canada/group-resps-reading-the-fine-print-1.975107